Fed's Hoenig: Too-Big-to-Fail Policies Disadvantage Community Banks

NEW YORK — The too-big-to-fail policies that have propped up the nation's largest banks are calling into question the outlook for the nation's community banks, a top U.S. central bank official said Monday.

"Because the market perceived the largest banks as being too big to fail, they have had the advantage of running their business with a much greater level of leverage and a consistently lower cost of capital and debt," Federal Reserve Bank of Kansas City President Thomas Hoenig said.

The official has been a persistent critic of policies he believes allows the nation's largest banks, the top 20 of whom hold 80% of the nation's total banking assets, to operate with the perception they will not be allowed to fail. Hoenig has worried that financial market reform efforts are falling short in their effort to deal with this problem, although he has softened his views a bit in the wake of recent Dodd-Frank Act, saying he will watch how regulators implement their new powers.

Hoenig is worried that community banks, which he believes are critical lenders to local communities, are at a disadvantage in the current environment. That's not good, because these banks are very important sources of credit in their areas, and are especially important in the area watched over by the Kansas City Fed.

"The decline in overall bank lending, particularly to small businesses, is a major concern," Hoenig said. But "data show that community banks have done a better job serving their local loan needs over the past year," he said, adding "community banks, as a whole, increased their total loans by about 2% as compared to a 6% decline for larger banks."

"Community banks have maintained a strong presence despite industry consolidation because their business model focuses on strong relationships with their customers and local communities," Hoenig said. "Larger banks are important to a firm as they grow and need more complicated financing, but in this region, most businesses are relatively small and their needs can be met by that local bank."

Hoenig's comments came from the text of a testimony that was to be delivered before the House of Representative's Subcommittee on Oversight and Investigations, which was holding a gathering in Overland Park, Kan.

Hoenig is a voting member of the interest rate-setting Federal Open Market Committee, and a prominent critic of the current course of policy. Unlike the rest of the FOMC, he believes the central bank needs to raise rates now to prevent the fresh buildup of financial imbalances. He has found few supporters for his views, and his remarks Monday steered clear of topics dealing with monetary policy and the economic outlook.

The relatively modest safety net afforded to community banks appears to have made them more prudent players in the financial system, Hoenig said.

"There is no better test of the viability of the community bank business model than the financial crisis, recession, and abnormally slow recovery that we've experienced over the past 2 1/2 years," Hoenig said. "The community bank business model has held up well when compared with the megabank model that had to be propped up with taxpayer funding."

Hoenig noted there are other challenges faced by community bankers. "For community banks that survive, it will be a struggle to recover," he said. "Commercial real estate, particularly land development loans, will be a drag on earnings for some quarters yet."